[UPDATED 7/22 – Added information about Secret Service Operation Open Market and its relationship to the shut down of Liberty Reserve.]

*Them that has the gold, makes the rules.

For the last decade or so, governments and mainstream businesses have been taking incremental steps towards recognizing the value of virtual goods and currencies.

As early as 2005, the NY Times reported that there were over 100,000 people employed as professional “gold farmers” in China. In 2008, the US National Taxpayer Advocate, in her annual report to Congress (PDF), recognized that the digital assets acquired in virtual worlds have real world value and recommended that the IRS take steps to clarify the tax issues around the trading of those items. (The relevant portions of the report are extracted here.) Also in 2008, China imposed an income tax of 20% on income derived from the online trade of virtual currencies.

In 2011, Chinese insurance company Sunshine Insurance Group introduced a “virtual property” insurance product,
to address “an increasing number of disputes between online games operators and their customers, which are often related to the loss or theft of gamers’ virtual property such as ‘land’ or ‘currency’.”

This year we’ve seen an acceleration of action in the financial and governmental arena related primarily to virtual currencies and their poster child, the “cryptocurrency” Bitcoin.

In March, the US Dept. of Treasury Financial Crimes Enforcement Network (FINCEN) issued what is so far the most specific piece of regulatory Guidance on the financial regulatory issues with virtual currencies (FIN-2013-G001 “Application of FinCEN’s Regulations to Persons Administering, Exchanging, or Using Virtual Currencies”). This guidance clarifies the applicability of the Bank Secrecy Act (“BSA”) to entities creating, obtaining, distributing, exchanging, accepting, or transmitting virtual currencies, and relate to a wide variety of virtual currencies. The Guidance applies to those who are “exchangers” and “administrators” of virtual currencies, rather than “users” of virtual currencies. Basically, if you acquire virtual currency and then use it to buy something else – virtual or real – you’re a user; if you trade virtual currencies, you’re an “exchange;” and if you issue/redeem a virtual currency, you’re and “administrator.” For more in depth analysis of the FINCEN Guidance, go here (PDF).

In April, a bar in NY became the first real world business to accept Bitcoin (although the first transaction trading real world goods for Bitcoins is believed to have been in 2010). At the same time, Fox News reported that with over $1 billion in Bitcoins in circulation, the Bitcoin economy exceeded the economies of 20 other countries.

With all that money at stake, you can be sure the tax authorities are taking notice, and in May, the U.S. Government Accountability Office issued a report (PDF) detailing the tax-reporting requirements for virtual currencies and the inherent challenges in trying to achieve compliance. BNA has a good article on some of the tax issues associated with use of currencies like Bitcoin.

If you think you might be an “exchange” or an “administrator” and you do business in the US, I strongly recommend you seek legal counsel, because on May 17 Federal authorities seized a bank account associated with one of the leading Bitcoin exchanges on the grounds that the account owner, Mutum Sigillum LLC (a subsidiary of Japan-based Mt. Gox, the world’s biggest Bitcoin exchange), was not registered as a money transmitter in violation of 18 USC § 1960 – Prohibition of unlicensed money transmitting businesses. Then on May 28, the U.S. Dept of Treasury designated Liberty Reserve S.A., a virtual currency provider, as a financial institution of primary money laundering concern under § 311 of the USA PATRIOT Act on the grounds that its virtual currency is “specifically designed and frequently used to facilitate money laundering in cyber space.” At the same time, the U.S. Attorney’s Office for the Southern District of New York unsealed an indictment that charged Liberty Reserve and seven of its principals with allegedly running a $6 billion money laundering scheme and operating an unlicensed money transmitting business. For more information about the government’s investigation into Liberty Reserve, see this article.

With all of this attention from financial regulatory authorities, it’s no wonder that US banks are getting leery of Bitcoin businesses. In April, the world’s fourth-largest Bitcoin exchange, BitFloor, had to close down after its bank closed the company’s account. Given the risk of disruption, many Bitcoin-based businesses have been looking over their shoulders in fear that their banks will decide to shut them down.

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About John Nicholson

I'm a transactional attorney who focuses on structuring and negotiating large outsourcing transactions (both on and offshore).
As part of my work, I've specialized in:
- Structuring and negotiating large outsourcing transactions (both on and offshore) including IT outsourcing and various BPOs (including HRO, Facilities Management, Procurement, Finance and Accounting), large systems development and implementations;
- Assisting with development of RFPs, proposal evaluation, down select, and negotiation;
- US and European privacy laws, including US Safe Harbor, and state privacy and data breach notification laws; and
- Privacy, security, legal and contractual issues associated with cloud computing.
I'm a frequent speaker on outsourcing, privacy and security issues.
Before becoming a lawyer, I was the acting IT director for a mid-size company prior to hiring the CIO and project manager for the company's Oracle Financials implementation.